by Sebastian Mullins – Deputy Head, Multi-Asset Australia
On February 24th, Russian forces launched a large-scale military invasion of Ukraine. Diplomatic efforts and ceasefire negotiations have so far failed. President Putin has been strongly opposed to NATO expansion within Russia’s sphere of influence and has been pushing for a neutral and de-militarised Ukraine ever since the country’s 2019 constitutional commitment to join NATO. Ukraine feels its sovereignty is under siege, as independent countries have the right of self-determination and the right to defend themselves against their neighbour. It seems unlikely at this stage that either country will capitulate on these fundamental points and therefore a pathway to de-escalation remains elusive.
While the fighting intensifies in Ukraine, geopolitical risk continues to rise. Putin has put Russia’s nuclear forces on high alert, and Belarus has renounced its non-nuclear status, paving the way for Russia to put nuclear capabilities along the border with Poland and other NATO members. Germany has decided to increase their military spend to remilitarise and the ex-Prime Minister of Japan Abe-san has floated the idea of allowing US nuclear warheads to be stationed in Japan, two formerly pacifist nations post World War 2. Historically neutral Switzerland and Sweden have taken sides, either by sanctioning Russia or by supplying arms to Ukraine. China also appears to be distancing itself from its ally, urging both sides to de-escalate, abstaining at the UN Security Council vote to condemn the invasion (rather than voting against) and stating it respects all countries’ sovereignty, including Ukraine’s.
Liquidity risks appear
The West is helping Ukraine by supplying arms and training but cannot yet intervene with boots on the ground given Ukraine is not a NATO member, so instead has been hitting back at Russia economically. Russia has built up a significant amount of foreign currency reserves, however, the West’s sanctions have essentially frozen approximately 75% of these reserves, removing the liquidity the central bank needs to defend its currency. The Russian ruble has fallen over 26% for the month of February, despite the central bank doubling official rates to 20% and implementing capital controls to help stem capital outflows. While the Russian stock market remains closed, the published NAV of the US listed VanEck Russia ETF is down 95% since mid-February. It is too early to tell if there will be any contagion reverberating through global markets, but the recent move in European bank equities and investment grade credit spreads suggest the market is anticipating broader liquidity risks.
At a macro level, the recent spike in commodity prices and the impact on global inflation should be watched closely. Inflation expectations remained elevated in 2022 and the recent surge in commodity prices further extends the timeline for inflation to normalise. This puts central banks in a bind. Do they stay hawkish to quell inflation, tightening into a slowdown and potentially pushing the economy into a recession? Or do they turn more dovish in an attempt to stabilise the economy, potentially letting inflation become entrenched or even unanchored?
Our defensive position proves prudent
A clear thesis to us for 2022 was that volatility in markets would rise, and that risk assets would have a harder time delivering in a period where the policy cycle has turned from a tailwind into a headwind. The Ukraine conflict is an additional complication. Our focus on managing downside risk in an environment of elevated valuations and rising inflation meant we had positioned the portfolio more defensively ahead of the conflict. The rebound in global equities in early February was a good opportunity to further reduce equity exposure to 25%. This is almost a 13% reduction from our peak in early November 2021. We have been leaning towards quality within equities, rather than the more expensive growth stocks, to increase the defensiveness of our equity allocation. We’ve also been leaning on commodities and relatively moderate duration to protect us against higher inflation. As such, our calendar year-to-date return to the end of February of -1.7% (net of fees) compares very favourably to returns for the major asset class indices over the same period; global equities -7.3%, Australian equities -4.3%, global aggregate bonds -2.9% and the AusBond composite -2.2%.
A further benefit of our strategy is the breadth of asset classes we can access. While we have reduced our exposure to mainstream credit markets by 8% from our late 2021 peak, primarily via reductions in high yield, we have maintained allocations to Australian private credit and commercial real estate mortgages, which have continued to provide steady income without pricing volatility, along with insurance linked securities which are uncorrelated to bonds and equities. We continue to increase duration exposure (currently at 1.75 years) to increase our defensiveness and continue to hold higher levels of cash to help dampen volatility during these times of uncertainty.
Thanks to our active approach to security selection, within our emerging market allocations we had very small allocations to Russian local currency bonds and EM equity exposure was biased towards Asia. In addition, our currency exposures to the ruble were hedged. As such, at the end of February we held minimal exposure to Russian assets (less than 0.1%), which we intend to cut to zero when appropriate, and once liquidity returns to this market.
